How A German Balance Sheet Recession Fueled The Euro Crisis

Richard Koo wrote yesterday that basically you really can't blame countries like Greece for their own competitiveness problem. It was all ECB's fault.

The idea was that Germany was suffering a balance sheet recession in early 2000s after the IT bubble while the south of Europe did not. Maastricht Treaty prohibits euro area member state to run budget deficits of more than 3% of GDP, so fiscal stimulus was not available for Germany (note that Germany did breached the 3% deficit target though for a few years after the bubble). Thus, according to Richard Koo, the only way to stimulate the German economy is for the ECB to ease monetary policy, which was appropriate for Germany, but inflationary for the rest of Europe. And that was why there were bubbles in the periphery.

In short, the ECB's ultra-low policy rate had little impact in Germany, which was suffering from a balance sheet recession, but it was too low for other countries in the eurozone, resulting in widely divergent rates of inflation. As Germany became increasingly competitive relative to the strong economies of southern Europe, exports grew sharply and pulled the nation out of recession. Germany's trade surplus quickly overtook those of Japan and China to become the world's largest, with much of the growth fueled by exports to other European markets.

The chart below shows the outstanding loans in euro area by country. As you can see, the lack of loan growth in Germany appears to be consistent with the idea that there was a balance sheet recession (or debt deflation, if you like) in Germany. On the other side, you have what we now call the PIIGS countries which loans continued to grow. Most notably here, of course, is Spain, with rapid loan growth fuelling its real estate bubble.